High-Speed Trading in the Spotlight

Former Trader to Testify on Hill About Techniques He Says Put Ordinary Investors at a Disadvantage

By

Scott Patterson

Updated Sept. 19, 2012 6:47 p.m. ET

WASHINGTON—An insider of the secretive world of high-frequency trading is set to attack that industry Thursday on Capitol Hill, giving lawmakers a potential road map to address practices that critics say can put ordinary investors at a disadvantage and the financial system at risk.

WSJ's Michael Siconolfi explains how high-frequency traders undercut everyday stock traders and unfairly jump again in the line for order fulfillment.

Since rapid-fire trading firms now provide many of the buy and sell orders that support the market, investors are at the mercy of automated systems that can run amok during volatile times, according to
Dave Lauer,
who last year quit his job as a trader for an elite Chicago high-frequency trading outfit.

ENLARGE

Dave Lauer, pictured above near the U.S. Capitol Building on Wednesday, last year quit his job at a Chicago high-frequency trading outfit.
Eli Meir Kaplan for The Wall Street Journal

Mr. Lauer is part of a growing chorus of industry insiders blowing the whistle on approved trading techniques that they say are designed by the traders who derive the most benefit. Mr. Lauer is now a consultant on market-structure issues for Better Markets, a Washington, D.C., advocacy group funded by a hedge fund.

He plans to tell senators how he came to believe that high-speed trading has made the market less fair for many investors, according to his advance testimony for a Senate panel on computerized trading.

One way sophisticated firms get an edge over other investors is the use of complex order types, which are commands that traders use to tell exchanges how to handle their buy and sell orders, according to Mr. Lauer.

ENLARGE

A series investigating a new age of murkiness in the financial markets and the challenges that creates for investors.

Regulators are looking into whether exchanges, in a rush to gain the business of high-frequency firms, have provided advantages to some sophisticated trading firms that allow them to trade profitably at the expense of other investors, according to people familiar with the continuing probes. High-frequency trading accounts for some two-thirds of all trading volume, experts say.

The SEC is conducting an inquiry into whether high-frequency firms use those order types to jump in front of other investors. In a page-one article Wednesday, The Wall Street Journal reported that
Haim Bodek,
who helped run a high-frequency trading firm, told SEC enforcement officials last year that he believed exchanges were giving certain sophisticated trading firms special advantages that helped them beat out other investors.

Another critical voice comes from the mutual fund industry.
Andy Brooks,
head of U.S. stock trading at
T. Rowe Price Associates
Inc.,
plans to say that "most rules and regulations seem to further enable those with short-term profit incentives, as evidenced by the proliferation of new order types suggested by exchanges and approved by regulators."

The hearing of the Senate Banking subcommittee, led by Sen.
Jack Reed
(D., R.I.), comes amid heightened scrutiny of ties between high-frequency firms and stock exchanges, which have come to rely on the rivers of buy and sell orders the firms provide.

Last week, the Securities and Exchange Commission said it fined
NYSE Euronext
$5 million for sending data to some clients faster than it sent data to the public, allegations the NYSE neither admitted to nor denied.

Defenders of high-frequency trading, in which firms send waves of buy and sell orders into the market, often canceling them, say it makes trading more efficient and cheaper for everyday investors.

The U.S. stock market "is the most dynamic and efficient market in the world,"
Chris Concannon,
executive vice president of Virtu Financial LLC, a New York high-speed trading firm, will tell the Senate panel, according to his prepared testimony.

Mr. Lauer believes the complexity has reached such a high level that it has made the market extremely fragile and at risk of devastating crashes. "We are truly in a crisis," Mr. Lauer plans to tell the Senate panel

His first job at a high-frequency trading operation was as a quantitative research analyst at Citadel, a giant Chicago hedge fund, which he joined in early 2009. Later, Mr. Lauer, with several other Citadel traders, moved to the high-speed Chicago firm Allston Trading. He says he got his first glimpse into the extreme risks posed by superfast computer trading on the afternoon of May 6, 2010. He watched from Allston's trading floor as stocks started to plunge due to glitches in computer systems across the market, a meltdown later dubbed the "flash crash."

As the downdraft worsened, he says an executive for the firm ran on to the trading floor and gave the order to pull out of the market. In seconds, Allston's traders complied, getting out of their positions and canceling their offers to buy and sell to avoid losses from an extreme market swing.

The move was mirrored by other high-frequency firms, making the "flash crash" worse, since the firms were no longer standing ready to buy stocks other investors were selling.

Another trend that he says concerned him: the central role high-frequency firms play in the trading of exchange-traded funds. He says many ETF firms court high-frequency traders, which help provide the buy and sell orders that can make ETFs easier to trade for other investors.

The problem, Mr. Lauer says, is that ETF firms at times give high-frequency traders access to the inner mechanics of how the ETFs operate. For instance, an ETF firm often needs to buy and sell stocks that make up the funds in order to adjust for moves in the market, which is called "rebalancing."

High-frequency firms, he says, knew when such rebalancing occurred. The firms "would just front run them," he says.

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